RISK-RETURN ANALYSIS

CONTENTS

• Objectives
• Risk-return relationship
• Means of measuring Risk
LEARNING OBJECTIVES

• To discuss the relationship between risk and return of a

single asset.
• To understand the various types of risk under the broad
category of systematic risk and unsystematic risk
• To analyse the means of measuring risk such as beta,
standard deviation and variance.
INTRODUCTION

• Risk is present in virtually every decision. When a

production manager selects an equipment, or a
marketing manager an advertising campaign, or a
financial manager a portfolio of securities, all of them
face uncertain cash flows.
• Assessing risks and incorporating the same in the final
decision is an integral part of financial analysis.
INTRODUCTION (2)

• The objective in decision making is not to eliminate or avoid risk—

often it may be neither feasible nor desirable to do so – but to
properly assess it and determine whether it is worth bearing.
• Once the risk characterising future cash flows is properly
measured, an appropriate risk-adjusted discount rate should be
applied to convert future cash flows into their present values.
RISK-RETRUN RELATIONSHIP

• Financial decisions often involve alternative courses of

action.
• Should the firm set up a plant which has a capacity of one
million tons or two million tons?
• Should the debt-equity ratio of the firm be 2:1 or 1:1?
• Should the firm pursue a generous credit policy or niggardly
credit policy?
• Should the firm carry a large inventory or a small inventory?
RISK-RETRUN RELATIONSHIP (2)

• The alternative courses of action typically have different risk-return

implications.
 A large plant may have a higher expected return and a
higher risk exposure, whereas a small plant may have a
lower expected return and a lower risk exposure.
 A higher debt-equity ratio, compared to a lower debt-
equity ratio, may save taxes but expose the firm to
greater risk.
 A ‘hot’ stock, compared to a defensive stock, may offer a
higher expected return but also a greater possibility of
loss.
RETURN
• Arithmetic Mean of Annual Returns Provided by Nifty 50
RISK

• In finance, risk is the probability that actual results will differ from
expected results.
• In the Capital Asset Pricing Model (CAPM), risk is defined as the
volatility of returns. The concept of “risk and return” is that riskier
assets should have higher expected returns to compensate investors
for the higher volatility and increased risk.
Capital Asset Pricing Model (CAPM),

• The Capital Asset Pricing Model (CAPM) is a model that describes the relationship
between the expected return and risk of investing in a security. It shows that the
expected return on a security is equal to the risk-free return plus a risk premium,
which is based on the beta of that security.
Capital Asset Pricing Model (CAPM) (2)

• The CAPM formula is used for calculating the expected returns of an

asset.
• It is based on the idea of systematic risk (otherwise known as non-
diversifiable risk) that investors need to be compensated for in the
form of a risk premium.
• A risk premium is a rate of return greater than the risk-free rate. When
investing, investors desire a higher risk premium when taking on more
risky investments.
TYPES OF RISK

Systematic Risk

Unsystematic Risk
SYSTEMATIC RISK

• Systematic risk is risk within the entire system. This is the kind of risk that
applies to an entire market, or market segment.
• All investments are affected by this risk, for example risk of a government
collapse, risk of war or inflation, or risk such as that of the 2008 credit
crisis.
• It is virtually impossible to protect your portfolio against this risk. It cannot
be completely diversified away.
• It is also known as un-diversifiable risk or market risk.
TYPES OF SYSTEMATIC RISK

1.Interest-Rate Risk: It refers to the risk arising from the

change of market interest rates and affects fixed income
instruments like bonds. E.g., Government reducing/increasing
interest rates would affect securities valuation.
2.Market Risk: It refers to risk arising out of changes in the
market price of securities that cause a significant fall in the
event of a stock market correction. E.g., A stock market
correction would wipe out wealth created by fund managers
and affect the whole company.
TYPES OF SYSTEMATIC RISK

1.Exchange Rate Risk: It appears out of changes in the

value of currencies and affects corporations with
substantial foreign exchange transaction exposure. E.g., A
devaluation of other countries’ currencies would make
imports costlier.
2.Political Risk: It is mainly due to political instability in any
economy. It involves business decisions. E.g., A
government declaring war would lead to the withdrawal of
foreign funds.
UNSYSTEMATIC RISK

• Unsystematic risk is also known as residual risk, specific

risk or diversifiable risk. It is unique to a company or a
particular industry.
• For example strikes, lawsuits and such events that are
specific to a company, and can to an extent be diversified
away by other investments in your portfolio are
unsystematic risk.
HOW TO MEASURE SYSTEMATIC RISK

• Beta (β) is a measure of the volatility—or systematic

risk—of a security or portfolio compared to the market as
a whole (usually the S&P 500). Stocks with betas higher
than 1.0 can be interpreted as more volatile than the S&P
500.
• Beta is used in the capital asset pricing model (CAPM),
which describes the relationship between systematic risk
and expected return for assets (usually stocks).
• The S&P 500 has a beta of 1.0.
BETA

• where:
• Re=the return on an individual stock
• Rm=the return on the overall market
• Covariance=how changes in a stock’s returns are
related to changes in the market’s returns
• Variance=how far the market’s data points spreadout from their
average value
Formulas

• Variance

• S^2 = sample variance

• xi = the value of the one observation
• bar{x} = the mean value of all observations
• n = the number of observations
Formulas

• Co-Variance

• cov_{x,y} = covariance between variable x and y

• xi = data value of x
• yi = data value of y
• bar{x} = mean of x
• bar{y} = mean of y
• N = number of data values
CONTD..

• The beta calculation is used to help investors

understand whether a stock moves in the same
direction as the rest of the market.
• It also provides insights into how volatile–or how
risky–a stock is relative to the rest of the market.
• For beta to provide any useful insight, the market
that is used as a benchmark should be related to
the stock.
 CALCULATION OF BETA
Date Stock Price Benchmark Monthly Return on Monthly Return
Price (Nifty Asset (F) on Index (G)
Index)
1-Jan-2022 232 1274 0.92 0.15
1-Feb-2022 446 1460 -0.34 -0.24
1-March-2022 294 1110 0.09 0.24
1-April-2022 321 1376 1.27 -0.04
1-Jun-2022 730 1316 -0.11 -0.01
1-July-2022 648 1300 0.08 0.04
1-Aug-2022 703 1351 0.04 0.03
1-Sep-2022 728 1396 -0.05 0.03
1-Oct-2022 689 1440 -0.68 -0.2
1-Nov-2022 220 1148 1.71 0.09
1-Dec-2022 597 1247 -1 -1
CONTD..

• Variance:=VAR.S(G5:G15)= 0.6653
• Covariance=COVARIANCE.S(F5:F15,G5:G15) =0.16440
• Beta=

• Beta= 0.111/ 0.6653

• =0.1676 which means that the company is less volatile
than the market.
 STANDARD DEVIATION

• Standard deviation is a statistical measurement in finance

that, when applied to the annual rate of return of an
investment, sheds light on that investment's historical
volatility.
• Standard Deviation (SD) is a technique of statistics that
represents the risk or volatility in investment. It gives a fair
picture of the fund's return. It tells how much data can
deviate from the historical mean return of the investment.
 CONTD..

• The higher the Standard Deviation, the higher will be the

ups and downs in the returns.
• For example, for a fund with a 15 percent average rate of
return and an SD of 5 percent, the return will deviate in the
range from 10-20 percent.
• The higher the value of the standard deviation of returns,
the higher will be the volatility of returns. High volatility
means that high risk was apparent during the investment
period.
For a fund that has an average return of 7.5% and returns in its
subperiods were 13%, 11%, 2%, 6%, 5%, 8%, the SD will be −
CONTD..

• So, with an average return of 7.5% and a SD of

4.04%, the expected range of returns will be
between 3.46% (7.5% - 4.04%) and 11.54% (7.5% +
4.04%).
VARIANCE

• The most commonly used measure of variability in finance is

variance or its square root the standard deviation.
• In other words, the higher the variance, the greater the squared
deviation of return from the expected rate of return.
• For example, if you were looking at a specific stock’s price data
over a period of time, you may want to know how much the
stock’s price varies from the average price over that time period.
• The higher values indicate a greater amount of risk, and low
values mean a lower inherent risk.
• The Greek symbol used to designate the variance is σ2“squared
sigma.
Square Root of Variance =
Standard Deviation